Question

Using an example from your organisation, differentiate between “period costs” and “product costs”.

According to the Capital Asset Pricing Model (CAPM), investors will have to face “diversified risk” and “non-diversifiable risk”.
Distinguish between the two.

Answer 1

DIFFERENCE BETWEEN DIVERSIFIABLE RISK AND NON DIVERSIFIABLE RISK

1. DIVERSIFIABLE RISK

Diversifiable risk arises due to micoeconomic factors within the organisation, such that if proper action is taken against them, such risk can be avoided. This type of risk which is firm specific and can be avoided is also referred to as unsystematic risk. For example: Labor Strike. It arises only for a particular company unlike systematic risk which affects all the companies in the same manner.

It can be either:

a) Financial risk

b) Business risk

Hence, Diversifiable/unsystematic risk = Business Risk + Financial risk

2. NON-DIVERSIFIABLE RISK

Non-diversifiable risk is also called market risk as it is caused due to macroeconomic factors and affects all the firms/companies in the same manner. For example: a natural disaster will affect all the companies, no matter which industry they belong to, in the same manner. Such risks cannot be diversified away hence are called non diversifiable risk or systematic risk.

These can be categorized as:

a) Interest Rate risk

b) Inflation Risk

c) Market Risk